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FINANCE Minister Pravin Gordhan's 2013 Budget Speech was on the surface much as we expected – “boring”, with an admission that there was virtually no room for manoeuvre.

There were no major new expenditure announcements, nor significant tax increases. Revenue underperformance combines with downwards revisions in the gross domestic product (GDP) forecast to make for a slower pace of fiscal consolidation.

The message was very much “steady as she goes”, with a few additional spending flurries paid for by savings of some R10.4bn over the expenditure outlook period and reduced contingency funds. As such, on the headlines we judge the budget to be ratings neutral.

However, there was a nasty surprise with the wider deficits being paid for by increased borrowing in the local bond market. This is more ratings negative. Overall, however, this was mainly a “holding” budget.

Significant holes on both the revenue policy side and expenditure policy side exist that will be filled only later in the year as a result of the National Treasury’s long-run and ever-delayed expenditure study and the tax commission. This is where the true risks to the ratings, debt levels and issuance, lie.

There was a distinct lack of detail (and we judge an inability fiscally to offer details) around the National Develpoment Plan (NDP), nor was there enough detail for our liking on how infrastructure underspend can be dealt with.

In addition, the form of youth wage “incentive” announced seems a much watered-down and more timid version than the original. Some of the increases in public sector employment costs were perplexing.

There was no change to the South African Reserve Bank (Sarb) mandate.

The budget backdrop

The background of the 2013 Budget was a meaningful revision down in growth numbers – from 3.0% to 2.7% for the current calendar year, and from 4.1% to 3.8% in 2015 (which we think in part reflects a lower assumption of medium-run potential growth).

The forecasts are now much more realistic in our view, though still a little too optimistic regarding the economy having a meaningful bounce-back next year. On inflation they are a little more optimistic, though the GDP deflator as opposed to consumer proce index (CPI) sees less change.

As such, the reductions in nominal GDP are an important factor in the shift in consolidation.

The lowering of the medium-run growth number is particularly important, however. It links in with a line in the budget speech relating to the forthcoming tax commission.

Gordhan said that the government hoped a 5%+ growth rate emanating from implementation of the NDP would result in doubling of tax revenues over 20 years and that only if that didn’t occur then there would have to be a meaningful reassessment of tax policy.

However, we doubt that such an assumption is achievable based on the government process (and infighting that we perceive) on the NDP.

As such, we think there remains a significant medium-run hole in the revenue side that the future tax commission may well only address if its terms of reference are realistic (in other words, suitably pessimistic on the medium-run economic outlook and potential growth).

Further to this, there was a lack of specific plans or spending streams assigned to NDP implementation. While it is true the NDP is more of a roadmap, we think more targeted spending from the National Treasury could have helped boost its credibility and chances of success.

The other area of disappointment was that, while there was a trumpeting of the amounts being spent by the public sector on infrastructure, we found very little in the Budget Review to show any real move is being made to reduce underspend and make project implementation more efficient.

True, much of this is out of the hands of the National Treasury but it could have been more prominently raised. Indeed, underspend is further factored into the budget to help free up the expenditure side to account for increased expenditure on current items, including wages.

The budget specifics

The budget was marked by relatively small changes overall in the headlines, with more subtle shifts occurring underneath.

Between the medium-term budget policy statement (mini budget) and the budget, expenditure actually falls slightly this year and in 2015/16 accounted for mainly by savings and capital underspend as well as R10.4bn of savings and efficiencies the National Treasury hopes to deliver over the forecast period.

We think it probably can – the figure is modest and there have been a few successes recently, though more at central government level; the issue remains the provincial and municipality level as ever.

Revenues, meanwhile, are seen roughly flat in the coming fiscal year 2013/14 and thereon after, but falling this fiscal year substantially to account for the sluggish growth through H2 last year and specifically mining revenue tax after the problems in that sector.

The revenue shortfall for the current fiscal year versus last year’s budget stands at R16bn.

These subtle shifts combined with the lower growth assumptions in the denominator mean the budget deficit for the current fiscal year is seen now at -5.2% of GDP vs -4.8% of GDP at the mini budget (ie a deficit over 7% larger) and then at -4.6% vs -4.5%, -4.0% vs -3.7% and then back to -3.1% in fiscal year 2015/16 as was seen in the mini budget.

The primary deficit does not see the same consolidation path, however, given higher projected interest costs in line with budgeted high borrowing. As such, the end point for the primary balance is still a deficit. Indeed, debt service costs are seen plateauing at 2.8% of GDP now and out to the end of the forecast horizon.

We worry that while the shifts in GDP forecasts look very credible, the revenue assumptions, even taking into account the few small changes to increase tax on fuel and the carbon tax from 2015, from the personal tax and corporate tax multiplier assumptions look too large to us, particularly in 2014/15 and 2015/2015.

As such, in our view the risks to the budget are very much a larger deficit and slower pace of consolidation even under the government’s own assumptions from the revenue side – doubly so if you then factor in our weaker macro assumptions.

On the expenditure side there was a flurry of additional small spending commitments paid for by infrastructure underspend and rotations within expenditure, including the R10.4bn of savings.

In some cases efficiencies are clearly hoped for further down the line – for instance, underspend of municipal budgets this fiscal year is offset by an increase versus the mini budget in the 2014/15 fiscal year.

Once of the most perplexing areas of the expenditure side, however, is public sector wages. While expected to fall as a share of total expenditure over the forecast horizon, it is being revised up versus previous estimates – by 1.5% for the current fiscal year, by 3.0% for the coming fiscal year, and by 3.3% for the 2014/15 fiscal year.

Now the wage bill is seen growing at 7.9% in the coming fiscal year and by 6.3% in the one after. There is little in the budget review to suggest to us why this is occurring, and it seems to conflict with the previous comments that there is restraint on both pay and employment growth.

A crucial factor in keeping spending aligned while also having money in the kitty for a flurry of smaller projects and give-aways is the use of the contingency reserve – ie money is not being set aside.

This amounts to an additional R5.8bn this fiscal year, R7.9bn in the coming year, and a substantial R17.5bn in 2014/15 compared with the original assumptions in the mini budget. This, however, is not a sustainable budget position.

Overall then, fiscal consolidation is ever further postponed in the near term. Even if the headline deficit is seen reaching the end point in 2015/16, it seems unrealistic to us given the balance of risks and hence we continue to factor in a much slower path of fiscal consolidation based on current policy.

We should also note that there is no attempt here at headline consolidation in the classic sense – with revenues underperforming the growth rate in real terms, expenditure still remains flat on the previous year, though over the medium run consolidation is achieved by real revenue growth and real expenditure growth falling back to 2.3% next year from 4.3% this year and to 1.2% in 2015/16 fiscal year.

We think such low levels of real expenditure growth are ultimately politically impossible, with pressure on social wage increases, infrastructure and wider developmental state delivery against a background of a central state that is improving in efficiency but a sub-central public sector that is not (even in some cases going into reverse).

This highlights the fundamental hole on the expenditure side as growth recovers, albeit only to a still low potential growth rate by the end of the forecast horizon.

Add in policy change holes too on the National Health Iinsurance (NHI) and additional, as yet barely planned for, infrastructure and also some risk of additional spending to ameliorate the burgeoning unrest not only in the labour market but around service delivery at a local government level too.

This is why the tax commission later in the year is so crucial, when combined with the ever-delayed government report on long-run expenditure pressures. For a credible National Treasury the only way out in our view is to increase taxes, including levying a new mining super tax – even if Gordhan was rather coy on the issue on Wednesday.

For us, however, the politics around increasing tax before the election as well as its effect on both current and potential output is key. A larger tax take would be undertaken to pay for increased spending. But we doubt it would be used for promoting fiscal consolidation or reducing debt levels. Funding and the agencies

The funding of a larger deficit is done mainly via increased long-term local market bond issuance. This came as a surprise to us, along with the increase in short-run debt issuance in the last two years of the funding window.

We had expected deposits to be run down further, but instead the contingency reserve was tapped. FX debt issuance is also seen as being slightly higher though likely mainly on currency forecast moves. For the local market, however, the numbers are quite significant, with an increase of R20bn seen in 2015/16 and R14bn the year before.

The numbers are partially offset by declines in some public sector borrowing reflecting underspend, though net this effect is actually marginal in our view.

Debt levels have been revised up in gross terms to 44.6% of GDP in fiscal year 2015/16 from 42.7% at the mini budget (we forecast 47.6% for the same period) and in net terms from 40.3% to 39.2% in the same period.

The move is counter to previous reassurances about the debt level not breaching 45% in gross terms; that may well now happen in 2016/17 by the government’s own forecast.

The debt issuance and debt level increases are likely to be the key concerns for the rating agencies, and hence we expect some negative comments from them in the coming weeks. However, we see nothing here to prompt a downgrade in itself.

The agencies will likely want to wait for clarity and the outcomes from the tax commission and the long-run expenditure report first before acting on that front.

We still maintain though that under our assumptions of a much slower pace of fiscal consolidation even after these events, the skew to ratings is very much to the downside – especially when combined with the likelihood of additional violence, protest and strike action not only in the mining sector but around service delivery and more widely, plus the implementation of policies that hold back competitiveness (as the agencies termed them) like a mining super tax.

However, more fundamentally, we see the increased issuance of local debt and increased debt levels and a slower pace of budget consolidation at a time of wide current account deficits as alarming and a significant macro risk.

Indeed, the National Treasury is even more bearish than us in seeing the current account deficit in 2015 at a worrying -6.0% compared with our own forecast of -5.2%. This combines with a table in the Budget Review, showing that foreign investors have increased their holdings of local government bonds from 21.8% in 2010 to 35.9% last year.

This twin deficit risk out to 2015 – when global monetary policy should be much tighter and flows to emerging markets will likely have slowed markedly (if not reversed to a trickle outflow, we don’t see a major allocation back to developed markets) – will mean funding is a key challenge for the government, and there will be a step level rise in interest costs as the curve steepens increasing issuance requirements further.

This is why ultimately, even if not immediately, we think the government will be forced to raise taxes and cut spending to markedly reduce issuance levels back towards pre-crisis levels and make the system sustainable.

It is also why we see long-run fair value of the rand as being considerably weaker than this over the medium run for parallel reasons around the current account (and given flows, etc).

*Peter Attard Montalto is a director and emerging markets economist at Nomura. Views expressed are his own.

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